Beware the perils of paying CEOs with stock

FORTUNE — If regulators are serious about addressing compensation and risk at financial institutions, they ought to pay much closer attention to paydays that come in colors other than green.

The comment period for a proposed multi-agency rule that addresses executive compensation practices at financial institutions ended on May 31, but the proposed rule left a gaping hole in its failure to address the potential impacts of stock and options incentives on a financial institution’s risk profile and performance.

Research by professors Rüdiger Fahlenbrach and René M. Stulz in 2010, following the financial crisis, demonstrated why equity pay should not be ignored. While the knee jerk reaction is that if an executive is paid in equity, it will align that executive’s interests with the company’s shareholders, the research didn’t demonstrate any such benefits.

According to the research, “banks where CEOs had better incentives in terms of the dollar value of their stake [in the company] performed significantly worse than banks where CEOs had poorer incentives.”

All of those firms fared poorly in the crisis. They were either sold in distress, or in the case of Lehman, went bankrupt.

This research suggests that the banks with CEOs who had smaller equity ownership stakes performed better — and that perhaps equity ownership exacerbates rather than relieves problems with excessive risk taking by CEOs. Certainly, if a CEO has their eye on the stock price because they are paid in stock, that CEO has an incentive to soften bad news to shareholders and dampen full negative disclosures.

Regulators ought to pay attention to the fact that the evidence suggests that there is no positive relationship between a CEO’s performance and his or her stake in the company, especially given the risks to bank performance and the huge consequences to stakeholders.

So why don’t the regulators examine the issue of equity based pay more closely or address it in the proposed rule?

It’s not as if equity is a miniscule part of CEO pay. A quick review of the summary compensation tables in the latest proxies shows that the current CEOs of JP Morgan jpm, Bank of America BAC, Citigroup c and Wells Fargo wfc, received $127 million in equity and option awards over the last three years, which made up, on average, 80% of their total pay.

To address compensation at financial institutions, regulators need to examine all the reasons equity may create these perverse effects, including the fact that payments in equity may exacerbate the tendency to overpay executives (because of the false notion that equity and options are funny money and not real cash to the corporation).

Equity payments may also encourage managers to take risks, increase the volatility of returns, extract potential windfall benefits from timed sales, and manipulate stock prices. And it may do all of these things while diluting the stake of other shareholders, diminishing accountability to them, and distracting managers from the real business of managing the business.

If financial institution regulators examine the issues and carefully reflect on the impact of the proposed rule, maybe history won’t repeat itself. If they fail, we’ll be going through the same sad bailout saga all over again.

FORTUNE — If regulators are serious about addressing compensation and risk at financial institutions, they ought to pay much closer attention to paydays that come in colors other than green.

The comment period for a proposed multi-agency rule that addresses executive compensation practices at financial institutions ended on May 31, but the proposed rule left a gaping hole in its failure to address the potential impacts of stock and options incentives on a financial institution’s risk profile and performance.

Research by professors Rüdiger Fahlenbrach and René M. Stulz in 2010, following the financial crisis, demonstrated why equity pay should not be ignored. While the knee jerk reaction is that if an executive is paid in equity, it will align that executive’s interests with the company’s shareholders, the research didn’t demonstrate any such benefits.

According to the research, “banks where CEOs had better incentives in terms of the dollar value of their stake [in the company] performed significantly worse than banks where CEOs had poorer incentives.”

All of those firms fared poorly in the crisis. They were either sold in distress, or in the case of Lehman, went bankrupt.

This research suggests that the banks with CEOs who had smaller equity ownership stakes performed better — and that perhaps equity ownership exacerbates rather than relieves problems with excessive risk taking by CEOs. Certainly, if a CEO has their eye on the stock price because they are paid in stock, that CEO has an incentive to soften bad news to shareholders and dampen full negative disclosures.

Regulators ought to pay attention to the fact that the evidence suggests that there is no positive relationship between a CEO’s performance and his or her stake in the company, especially given the risks to bank performance and the huge consequences to stakeholders.

So why don’t the regulators examine the issue of equity based pay more closely or address it in the proposed rule?

It’s not as if equity is a miniscule part of CEO pay. A quick review of the summary compensation tables in the latest proxies shows that the current CEOs of JP Morgan jpm, Bank of America BAC, Citigroup c and Wells Fargo wfc, received $127 million in equity and option awards over the last three years, which made up, on average, 80% of their total pay.

To address compensation at financial institutions, regulators need to examine all the reasons equity may create these perverse effects, including the fact that payments in equity may exacerbate the tendency to overpay executives (because of the false notion that equity and options are funny money and not real cash to the corporation).

Equity payments may also encourage managers to take risks, increase the volatility of returns, extract potential windfall benefits from timed sales, and manipulate stock prices. And it may do all of these things while diluting the stake of other shareholders, diminishing accountability to them, and distracting managers from the real business of managing the business.

If financial institution regulators examine the issues and carefully reflect on the impact of the proposed rule, maybe history won’t repeat itself. If they fail, we’ll be going through the same sad bailout saga all over again.